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The price level — myth or reality
Frank Shostak
The popular way of thinking maintains that it is the duty of the central bank to stabilise the price level. Thus whenever the price level is going up this, it is held, lowers the buying power of money i.e., lowers the price of money. Conversely whenever the price level falls this raises money’s general purchasing power i.e. raises the price of money. In other words the price of money is the inverse of the price level. A careful scrutiny of this way of thinking reveals serious problems.
Thus, when the price of one kg of potatoes is one dollar we can say that the purchasing power of one kg of potatoes is one dollar and this is its money price. If the price of one kg of tomatoes is two dollars the purchasing power of one kg of tomatoes is two dollars which is again the same as its price. What, then, is the purchasing power of, or the price of a dollar? It will be a vast array of all the goods and services that can be purchased for a dollar, that is, of all the goods and services in the economy.
In our example we would say that the purchasing power of a dollar equals one kg of potatoes, or half a kg of tomatoes. In other words the price or purchasing power of one dollar will be an array of the quantities of goods and services that can be purchased for a dollar. Since the array is heterogeneous it cannot be summed up in some unitary price level.
We cannot add up half a kg of tomatoes to one kg of potatoes to one litre of milk etc. In other words general purchasing power of money cannot be meaningfully established. Since price level is the inverse of the purchasing power of money it implies that the price level cannot be quantified and thus established. So if price level cannot be established how is that we expect the central bank to stabilise it? What exactly must then be stabilised?
Not only can we not quantify the price level we cannot even tell the extent of money influence on the price of a particular good. The price of every good is determined by the demand and the supply for this good and by the demand and the supply of money. There are however, no means and ways to measure the impact of monetary change on a price of a particular good. For instance in period one a dollar buys one kg of potatoes and half a kg of tomatoes.
In period two one dollar buys 0.5 kg of potatoes and 1.5kg of tomatoes. Now, what can one say happened to the purchasing power of money over the two periods? All that we can say is that now one dollar buys 0.5kg of potatoes instead of one kg, 1.5kg of tomatoes instead of a half a kg. In other words we can describe what happened to each individual price.
However, we don’t know how much of the change in each price is due to a change in the demand/supply for good and how much is on account of a change in the demand/supply of money. Consequently it is not possible to tell what happened to the overall purchasing power of money. Since the purchasing power of money cannot be extracted from a price of a good obviously it is meaningless to construct various price indices and pretend that these indices can somehow measure changes in the purchasing power of money and hence also measure changes in the price level.
The absurdity of all this is not only that the popular way of thinking asserts the impossible, but that it also recommends that the central bank should respond to the changes in price indices, in order to attain its goal of price level stability. Rather than attaining stability, this type of policy leads to the destabilisation of the market economy.
Dr Frank Shostak is a former professor of economics who now works in the private sector
BrookesNews.Com
Monday 1 August 2005